What’s wrong with transportation markets and how do we fix them?

1. What’s wrong with transportation markets and how do we fix them? Christopher R. Knittel Department of Economics and Institute of Transportation Studies, UC Davis and NBER

2. Roadmap • The outcome of a well functioning market • “Thinking like an economist” • The different market failures in transportation/energy markets • How to fix them • Arguments against these fixes • Alternatives • Economics culture: please interrupt with questions or comments

3. The “first best” • To say a market is not working requires defining the optimum • Economists have a very specific notion of efficiency • Pareto efficiency: It is efficient, if it is not possible to reallocate resources and make one agent better off without harming another agent • Notice: nothing about equality • The idea is to maximize the size of the pie • If we don’t like the distribution of the slices, we address that through policies that don’t affect the size of the pie • These are transfers that don’t affect the actions of agents (more on this)

4. Market failures • If the market does not lead to a Pareto efficient outcome, we say it “fails” • It is the existence of market failures that opens the door for policymakers (and, thus governments) • Transportation markets have many failures • My plan is to discuss the main ones • Notice that this is powerful: If you can’t point to a market failure, then the market will maximize the size of the pie • Government intervention can only reduce the size (weakly)

5. Some principles of economics • People/society face tradeoffs • People respond to incentives • These seem obvious • People/firms think at the margin (and policymakers should too) • For example, consumers compare the cost of driving one more mile with benefit of driving one more mile • Or, firms compare the cost of selling one more gallon of gasoline with the benefit • Therefore, to influence behavior, you have change incentives “at the margin”

6. Trade can make everyone better off • Trade allows those firms more efficient at doing something (e.g., abatement) to do more of it • Trade maximizes the size of the pie, but doesn’t guarantee everyone gets a larger slice • The cost of something is what you give up to get it • “Opportunity costs” matter, not accounting costs

7. Some observations • The first best depends on the current system • The optimal transportation system if we were starting “from a clean slate” can be dramatically different compared to if we are not • This is the “at the margin” point. Sunk costs---those costs that have been incurred and cannot be recovered---do not and should not matter • So, fuels like hydrogen are (and should be) at a disadvantage, relative to starting from the beginning • The infrastructure for these fuels hasn’t been built, so these high capital costs are not sunk and should be considered • The optimal system can vary by country

8. If a consumer faces the true social cost of something and chooses to purchase it, then this is good for society • If you don’t agree with their decision, then either (a) you think you know more about their utility function than they do, or (b) you think their preferences are wrong • Most economists are hesitant to say (b) • Personally, I find it fairly elitist • (a) is possible if there is some lack of information, but we need to point to the information asymmetry • What does this mean? If the price of driving a Hummer included all of the social damages and someone wants to still drive it. Great!

9. Analyzing market failures • The ultimate goal is to understand how market failures affect efficiency and to design policies that correct these failures • Market failures come down to consumers/firms not facing the correct marginal incentives • Either prices or benefits are too high/low

10. Major market failures present • Externalities • Failure of agents to face “correct” costs/benefits • Network Effects/Coordination problems and investment spillovers • Failure of agents to face correct benefits • Market power • Firms pricing above their marginal cost (incorrect MB) • Asymmetric Information • Can lead to “missing” markets

11. The pillars of economics = marginal social cost S P First, the ideal P* = marginal social benefit D Q Q*

12. Negative externalities marginal social cost P = marginal private cost S DWL P* PNE = marginal social benefit D Q Q* QNE

13. Negative externalities in transportation • Pollution • Climate change (or risk of) • National defense • Congestion (time varying) • Accident risk (not discussed much) • In each case consumers/firms do not face the true cost of their decisions

14. Most frustrating part of being an economist • Solving the negative externality problem is simple • Place a tax on the item equal to the negative externality • So-called Pigouvian Tax • Advantages: • Direct, • Generates revenues, • Doesn’t require knowing Q*

15. Negative externalities Private cost + tax P S = marginal private cost t P* PNE = marginal social benefit D Q Q* QNE

16. Arguments against taxes • Political infeasible • I agree, but it remains our duty to continue to remind policymakers that it is the most direct and easiest way to solve the problem • They might be politically infeasible because we stopped doing this! • We should continue to calculate the social cost of this infeasibility • Major problem: we’re battling against oil and auto companies • Shameless cite warning: See, Fowlie, Knittel and Wolfram (2006) • Harms the poor disproportionately • Research suggests gas taxes are progressive up to the first 3 deciles, regressive from 4-10 • Remember, a tax generates revenue that can be distributed!!! • Proposition 87 was almost perfect

17. Arguments against taxes (cont) • Transportation demand is too inelastic for taxes to “work” • Shameless cite warning: See, Hughes Knittel and Sperling (En. Jo. fthcmg) • Notice, this just suggests that Q* and QNE are close to each other • Suggests we should look elsewhere for carbon decreases, whether we like it or not • Price inelasticity and carbon inelasticity are not equal • Suppose there was an alternative fuel that had 25% less carbon, but always costs 10 cents more than gasoline • With no carbon tax, this fuel would never be sold • Even with a vertical demand: with a carbon tax of $0.41 per gallon, we would all switch to it, drive the same number of miles and carbon would fall by 25%

18. Arguments against taxes (cont) • Inelastic comment continued • Long Run elasticities difficult to measure • Not a perfect experiment, but there are major differences between US and Europe • VMT: The average car is driven 22% fewer miles/year • Ownership: Europeans own 30% fewer cars/person • Fuel efficiency: European cars get 41% better MPG • Total: Europeans consume 61% fewer gallons of gas

19. Arguments against taxes (cont)

20. Arguments against taxes (cont) Private cost + tax P S = marginal private cost P* t PNE D Q QNE Q*

21. Arguments against taxes (cont) • Requires knowing the damages • Yes. And these can be difficult to measure • What is the value of a polar bear? • But, any other policy instrument that I am aware of also requires this • And usually more • Lot’s of work on this: • Most comprehensive, Parry and Small (Am. Ec. Rev. 2006) • Risk, one paper Edlin and Mandic (J. of Pol. Economy 2006) • Congestion, lots of work • Infant Health (another warning: Knittel, Miller and Sanders [2008])

22. A nice alternative • An alternative to a tax is a cap and trade system • For example, gasoline refiners can face an aggregate carbon cap and be required to have a permit for every unit of carbon they “create” • They would then trade among each other • Very common in pollution market • The basis for Europe’s Kyoto compliance strategy, Northeastern NOx market for powerplants, CA’s RECLAIM market for NOx, Australia carbon market, etc.

23. Cap and trade • Why so common? • Not a tax • Permits are typically allocated in political way • This lessons the effect on firms and some firms can even profit • This gets the firms “on board” • Good thing: marginal incentives are independent of the initial allocation • First best is possible • Can tighten the cap until the permit price equals the negative externality

24. Cap and trade and S and D P marginal private cost PCAP PNE Permit Price = marginal social benefit D Q QCAP QNE

25. Arguments against cap and trade • Positive demand shocks can lead extreme prices • Australia’s solution -- cap the permit price at some level • In fact, you could cap it at the level of the externality! • We’re back to the tax solution • Effectively, this allows for an infinite number of permits at that price • Transportation demand is inelastic • See above. • Can’t have a cap on each driver • But, you can set it at the refinery level (for carbon) • For other pollutants, such as NOx, would require making assumptions on “typical” driving habits

26. Alternatives • Pollution: technology forcing (standards) • National defense: CAFE standards, LCFS, subsidies (negative taxes) • Climate Changes: LCFS, subsidies • Congestion: HOV lanes

27. New development in CA • LCFS exciting new development • Firms face a carbon intensity rate constraint • Holland, Knittel and Hughes (2007) work through the incentives of the firms: • Essentially: taxes fuels with carbon intensities above the standard, but subsidizes fuels with CIs below • All this is internal to the firm, so we never have to say “Taxx” • Can get the relative prices “right,” but low carbon fuels will be too cheap • Used as to solve other market failures?

28. (Indirect) network effects • So-called chicken and egg problem • E.g., hydrogen automakers need hydrogen refueling stations, hydrogen refueling stations need hydrogen automobiles • Exists in many industries – any hardware/software industry • Blueray/HD-DVD player manufacturers need content, content providers need players • This is the reason why Betamax died! • Mall store #1, needs mall store #2, and vice versa • Here, fixing the prices may not be enough (not completely true)

29. = marginal social cost S P P* marginal social benefit = marginal private benefit D Q Q* QNet

30. What do we learn? • Network effects can lead us to get “stuck” at a non-optimal equilibrium (Windows?) • We can also switch to a non-optimal equilibrium • Largely depends on consumers’ expectations • How do we solve them? • They occur because each side of the market doesn’t “internalize” the benefit to the other side • The obvious solution is for the two sides to “merge” • Alternatives: • They can coordinate, policymakers can set up consortia • Policymakers can set mandates • Suboptimal prices

31. Market power – the good market failure? • In almost every other industry, the market failure we worry about most is market power • Market power occurs when a firm’s output decision influences price • When this is the case, the firm no longer views its marginal revenue (revenue from selling one additional unit) as equal to the price • Why? Because in order to sell one more unit, the firm must lower the price on all of the existing units • Market power drives a wedge between price the social marginal cost; the supply curve is no longer the MC curve • So, we have “deadweight loss” from under consumption

32. Sources of market power in transportation • OPEC/Extraction • Cartels exist to increase market power • Shipping (?) • Refinery Industry • Retail Industry (probably small) • In theory, market power and negative externalities can fully offset each other • For example, if P=60, MPC=10, Negative Externality=50

33. Can they cancel? Just for fun…

34. Where do we go from here? • Unfortunately, the easiest and most direct way to solve many of the problems inherent in energy markets may not be politically feasible • But, we shouldn’t stop trying • Most of the alternatives create perverse incentives somewhere • (If not, they would be the preferred choice) • These perverse effects require additional policies, which… • We can’t lose trust in markets • Energy markets are failing, for the most part, because the prices are wrong • We can’t use arguments like “they’ve never worked in the past, so they won’t work in the future”